TESTIMONY OF
ANNETTE L. NAZARETH, DIRECTOR
DIVISION OF MARKET REGULATION
U.S. SECURITIES AND EXCHANGE COMMISSION
CONCERNING THE REPORT OF THE PRESIDENT’S WORKING GROUP ON
FINANCIAL MARKETS ON HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF
LONG-TERM CAPITAL MANAGEMENT
BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES
UNITED STATES HOUSE OF REPRESENTATIVES
MAY 6, 1999
Chairman Leach and Members of the Committee:
I am pleased to appear today to testify on behalf of the
Securities and Exchange Commission concerning the Working Group’s
findings on hedge funds and leverage in the wake of the near-
collapse of Long-Term Capital Management.
The Commission supports the Working Group’s recommendations
described this morning by Treasury. The Working Group carefully
studied the issues raised by LTCM and concluded that the lessons
to be learned from this episode center upon the risks posed by
the use of excessive leverage -- not just by hedge funds, but by
all large, significantly leveraged financial institutions. I
believe that the recommendations in the report represent a
balanced approach that addresses the problems of excessive
leverage without running the risk of driving hedge funds
offshore.
I would like to discuss briefly the Working Group proposals
that directly impact the SEC. Earlier in this hearing, you heard
about the break-down in market discipline among financial
institutions that extended credit to hedge funds. While no
securities firm was at risk of failing, securities firms did not
consistently adhere to prudent standards and, at times, to their
own written policies in their dealings with hedge funds. For
example, in their rush to do business with hedge funds,
securities firms often lent to and traded with hedge funds
without having a comprehensive view of their creditworthiness,
particularly their off-balance sheet positions.
Moreover, some securities firms did not adequately stress
test their exposures to hedge funds, leading them to
underestimate their level of risk exposure; and they often did
not factor concentration and liquidity risks into their risk
assumptions. Of course, during the third quarter of 1998,
statistical measurements of potential exposure became less
relevant as market volatility increased beyond the historical
levels incorporated into the risk models. In other words, many
firms did not realize that they were in a “100-year flood„
scenario, and as a result, they did not have adequate safeguards
built into their models to alert them to this fact.
In the wake of LTCM’s difficulties, the major securities
firms are attempting to improve some of the deficiencies in their
current risk models and procedures. In particular, firms are
requiring more comprehensive financial disclosures, enhancing
their stress testing for high risk hedge fund portfolios,
tightening their margin and collateral requirements, and updating
their risk models to reflect recent market volatility. We have
conducted examinations of the risk management procedures and
practices of the largest firms and intend to issue reports to
each firm recommending further improvements that we think are
necessary.
But more can and should be done. At Chairman Levitt’s
request, several large firms formed the Counterparty Risk
Management Policy Group to develop a set of best practices to
guide firms in formulating their risk management procedures.
This industry group intends to issue a report shortly. Moreover,
in its report, the Working Group recommended a number of
improvements to firms’ risk management procedures in such areas
as approving and monitoring credit, estimating potential future
credit exposures, setting limits on counterparty credit
exposures, and measuring leverage and risk. We will be working
with individual firms directly and with industry groups such as
the Counterparty Risk Management Policy Group to encourage
financial institutions to make these important improvements to
their procedures and to make them part of their corporate
cultures.
From the SEC’s perspective, the second key issue highlighted
by the LTCM crisis was
the need for better information on the hedge fund activity of
unregulated holding companies and affiliates of broker-dealers.
Although we receive comprehensive information about broker-
dealers’ direct exposures, if any, to hedge funds, the data we
receive about the exposures of their unregulated affiliates is
somewhat more limited.
Under the SEC’s current risk assessment rules, broker-
dealers and their major affiliates must report quarterly
information about their financial activities. This information
includes holding company financial statements and aggregate
securities holdings for each affiliate. It also describes the
broker-dealer’s policies for monitoring and controlling the risks
that major affiliates may pose for the broker-dealer. The SEC
also obtains, on a voluntary basis, information about the over-
the-counter derivatives activities of the unregulated affiliates
of five large U.S. broker-dealers through the Derivatives Policy
Group. Although this information is very useful, it does not
provide a complete picture of the potential risks that an
affiliate might pose to its affiliated broker-dealer.
As responsible regulators, we should have available more
comprehensive information about the potential risks that may be
incurred by the firms we regulate. For this reason, the SEC,
Treasury, and the CFTC recommended that Congress enact
legislation that would provide the agencies with expanded risk
assessment authority.
Under the Working Group’s proposal, the SEC would be given
new authority to require broker-dealers and their affiliates to
report credit risk information by counterparty. To further
strengthen our monitoring, this authority would also require
reporting of additional data on a firm’s concentrations in a
particular financial instrument, region, or industry sector, as
well as trading strategies and risk models. This information
would help us determine whether turmoil in a particular market or
sector was likely to have a negative impact on a particular firm.
For instance, if a firm’s affiliate had significant holdings in
Latin American debt and that region faced an economic crisis, we
could monitor that firm’s financial condition and activities more
closely.
Any expansion of SEC risk assessment powers, however, would
be ineffective if the SEC were not also given examination
authority over broker-dealer holding company affiliates. The
ability to inspect the books, records, risk models, and
management controls of broker-dealer affiliates, which the
Working Group also recommended, will help us ensure that the
reports prepared are complete and accurate.
We also learned from LTCM that more public information about
hedge funds and other highly leveraged entities, including
public companies’ exposures to these entities, should be made
available. The Working Group proposes that all public companies,
including financial institutions, be required to publicly
disclose a summary of direct material exposures to significantly
leveraged institutions, including hedge funds.
The required disclosure could be included in the narrative
material that is part of the periodic reports, such as Form 10-K
and Form 10-Q, that are filed by public companies with the
Commission. There is precedent for such disclosure. For
example, we currently require public companies to disclose their
material concentrations in high yield bonds. The Commission will
consider proposing a rule or interpretation to implement this
recommendation. The exact nature of the disclosure requirements
would be determined after we solicit and receive public comments
on the issue.
The Working Group believes that because the markets and
their participants are linked, the material financial exposure of
one market participant can create risks for those with which it
has financial dealings. Requiring public companies to disclose
their material exposures to significantly leveraged financial
entities should help impose private market discipline on public
companies, which in turn could indirectly curb potentially risky
exposures of unregulated entities, such as hedge funds, that
borrow from or trade with those companies.
A further key lesson we learned from LTCM was that more
public information about hedge funds should be available. To
help ensure that more timely and useful information about hedge
funds is made publicly available, the Working Group recommended
that Congress enact legislation to require hedge funds that do
not currently report to the CFTC as Commodity Pool Operators
(“CPOs„) to disclose certain financial information to regulators
and the public. The Report left open the mechanism for this
disclosure.
Relying on existing structures, the Working Group also
proposed that hedge funds currently registered as CPOs provide
enhanced information more frequently to the CFTC. This
information would be provided on a quarterly basis and would
include more meaningful and comprehensive measures of market
risk, such as value at risk or stress test results--although not
proprietary information on strategies or positions. I have heard
this proposed disclosure called “top down„ disclosure because it
would not require the hedge funds to tell the public the details
of their trading activities; rather, it would require them to
disclose how much risk they are assuming in their strategies.
In sum, we believe that the Working Group has made several
reasonable recommendations to address the issues raised by the
LTCM episode and generally has proved to be an effective
mechanism for addressing complex regulatory issues.
That concludes my testimony. I would be happy to answer any
questions you might have.